What Is Insurance & Reinsurance?

What Is Insurance & Reinsurance?
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Reinsurance, as defined by Princeton University's WordNetSearch 3.0 Online, is the "sharing of risk by insurance companies; part or all of the insurer's risk is assumed by other companies in return for part of the premium paid by the insured." This type of insurance can be thought of as insurance for insurance companies. Insurance is the coverage bought by individuals and businesses that promises to reimburse their losses due to accidents or catastrophes.

Characteristics of Insurance

Insurance varies by need and circumstance. Individuals purchase insurance for health, vehicle ownership, and home ownership. Businesses purchase insurance to financially guard against natural disaster and sometimes bankruptcy of the business. Insurance companies ask for a set amount of funds every month in exchange for varying amounts of coverage. Often, insurance companies also set a deductible, which is the amount the customer must pay for the loss before the insurance company covers the rest.

Characteristics of Reinsurance

Reinsurance is heavily characterized by low claims and high loss severity. This makes reinsurance extremely risky. Reinsurers risk absorbing a large disproportionate share of losses. Also, as claimants wait to make claims, knowing the amount of capital necessary to cover every catastrophe is almost impossible. Many reinsurance companies create reserves for late claimants, using past projections to estimate the size of the reserve. Despite the attempt to project the need for their services and reserves, these companies are often unable to correctly predict future needs. Therefore, reinsurance is a large, albeit necessary, risky business.

Types of Reinsurance

  1. Proportional reinsurance is defined as the insurer and the reinsurer sharing all premiums, and losses, covered by a pre-agreed upon prorated contract.
  2. Excess of loss reinsurance requires primary insurers to keep losses up to a certain level of retention, which is predetermined by the reinsurance company. The reinsurance company would then claim losses above the level of retention.

Purposes of Reinsurance

  1. Limiting liability provides an avenue for primary insurance companies to limit loss exposure equal to levels of their net assets.
  2. Stabilization is the process of insuring a company against wide fluctuations in profit and loss margins, stabilizing the company's overhead and operation results.
  3. Catastrophe protection insulates companies from two types of loss from catastrophe, large catastrophe such as the destruction of one large manufacturing plant, or many small catastrophe's such as the multiple small claims as the result of a natural disaster.
  4. Increased capacity is the measure, by dollar amount, of risk an insurer can assume. The capacity is based on the nature of the insurer's business and the surplus of the insurer.